Sunday, June 19, 2011

HP (Hewlett Packard) – Story of Hidden Pearls?

HP is the quintessential Information Technology Company. It has presence in multiple segments and is a great barometer of the tech spending. Its stock is also down significantly over the last year and in that aspect also it is a great representative of what is happening with big IT companies.

In the recent past it has gone through multiple changes including change of CEO – Mark Hurd to Leo Apotheker, reduction in revenue/earnings guidance and leakage of confidential memos from CEO. These are the things that you wouldn’t expect from a company which is consistently making money and which has performed well during the 2008-2009 crisis. All of the above has caused the stock price of the company to come down by more than 20% over the last year. The financial statistics of the company seemed appealing enough for me to take a deeper look.

Company Structure

Company is organized into the following key business segments:

Services

Enterprise Storage and Servers (ESS)

HP Software

Personal Systems Group (PSG)

Imaging and Printing Group (IPG)

HP Financial Services (HPFS)

Some segments like Services and Printing Group are more stable. The earnings and revenues come from long term contract and hence the revenues are more stable and margins higher. On the other end of the spectrum is PSG. HP is the market leader in selling PCs, Notebooks and handheld devices to both corporate and individual customers. However, PSG is an extremely competitive segment. Hence the revenue can have variability and the margins are lower. Others fall in between.

Below table provides the breakdown of Revenue and Profit by various segments.

Another interesting factor to look at is how these business segment revenues have changed YoY.

So overall the businesses held up quite well during the 2008-2009 crises. Infact, the services business grew as companies looked to reduce the expenses and outsource more technology work.

The above fact gives me the comfort that in adverse market situations the company should be able to ride out of the crises given its diversity of businesses. Next let us look at the valuation of the company.

Valuation

I have used annual reports for the 4 full years (2007-2010) and extrapolated the numbers from the 1st half of 2011 for 2011. This 5 year period is quite representative of the company’s performance since it includes the 2008-9 crises.

Assumptions:

I have assumed that 2011 numbers will be double of what has been observed in the 1st half so far.

Annual Growth is derived as annual compounding over the 5 year period.

MV has been derived by looking at the dilution share count at the end of period and multiplying by the market price at the end of the period.

EV is MV + s-t debt + l-t debt – cash – s-t investments

A few key things stand out:

Revenue and Profit (PAT) have grown at roughly the same pace 3.8% over the period. So HP has been able to keep the profit margin relatively constant.

MV has fallen -6.5% annually. A portion of this is because of the aggressive buy back that HP has embarked on over the last few years (more on this later). So while the share price wouldn’t have fallen by this %, because the share count has reduced, the MV has come down.

EV has not fallen as much. It has gone down by -4.9% annually which means that company has been leveraging up over this period. Lastly the BV has not moved much over the last few years again because of the share buy-back.

Finally, Valuation metrics looks very interesting.

oP/E has come down to 7.8 currently from 19 at end of 2007.

oEV/PBIT has come down to 6.8 from 15.5

HP has not been this cheap on the above metrics even during the 2008-09 crises.

We can safely surmise that HP is a cheap stock. But is it a value stock?

To understand this better let us look at the cash flow from HP over this period and how the company has used the Cash flow.

Cash Flow

When I look at Cash Flow, I am most interested in Owner’s Earnings or Owner’s Cash Flow. This is the cash flow that is available to the shareholders of the company to be used for distribution of dividends, repurchase of shares or to act as buffer during crises.

As can be seen from the above, HP has been a prodigious source of Operating Cash Flow – an average of 12.5 BN $ in a year. However, it is also a prodigious user of Cash, having spent more than 8Bn $ a year on Capital Expenditure and Acquisitions. Thus the average cash flow available in a year is only 4.5Bn $. For a company that is worth 86Bn $ of Enterprise Value, the return 4.5/86 = 5.23% is not appealing.

However, once you take away the acquisitions like year 2009 or year 2011 so far, the cash flow available to the shareholders become a lot more appealing. It generates around 10BN $ of Cash flow. Then the return is 10/86 = 11.6% is a lot more appealing.

Hence, if HP can tone down its acquisition spree that it has been on for the last 4 years, the stock can provide great return. Leo has also publicly stated that he is not looking to do any big acquisition. Whether he will be able to resist the temptation of doing acquisitions remains to be seen.

Lastly, let us look at how it has used the Cash flow that it has generated – 21BN $ over the last 5 years.

Usage of Cash Flow

HP has been a good steward of FCF that it has not spent on acquisitions. It has returned all of it in the form of stock repurchase which is an efficient medium of utilizing the cash. Here is a summary of how the Cash flow has been used.

Qualitative Factor

HP had a change of guard with Leo Apotheker coming in place of Mark Hurd. From the various presentations that I have seen, Leo is quite focused on generating shareholder value which is a good sign.

Recent management changes – reducing the hierarchy, increasing responsibility of key executives and bringing new blood should help reinvigorate the organization.

However, I don’t have enough data points to be absolutely sure on this front. So far based on everything that I have seen this area doesn’t seem to be a concern. This is also nothing to write about for the same reason. H business

ence this section is small.

Conclusion

HP is a very stable and solid that has been able to keep its profit margin over the last 5 years.

HP is currently trading at a cheap valuation compared to the historical norms as well as the valuation during the 2008-09 crises.

HP has spent a lot of money on acquisitions over the last 4-5 years. If HP can reign in its acquisition spree (or do acquisitions where it is getting as much in return for the price it is paying), this is a great opportunity to enter the stock.

Disclosure: I recently nibbled at HP stock. As there is more clarity regarding HP acquisition strategy or as the stock gets cheaper I will look to increase the position.

Disclaimer: All views expressed in this article are the author’s own views. They don’t represent the views of any company or organization that the author may be affiliated with. This is not a recommendation to buy or sell a stock. You need to do your own diligence before buying or selling a stock.